“Examine the record of history, recollect what has happened within the
circle of your own experience, consider with attention what has been
the conduct of almost all the great unfortunate, either in private or
public life, whom you may have either read of, or heard of, or remember;
and you will find that the misfortunes of by far the greater part of them
have arisen from their not knowing when they were well, when it was
proper for them to sit still and be contented.”
The Theory of Moral Sentiments
“There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”
In a world of low returns, increasing inequality, widespread mistrust of governments and regulatory agencies (more so since 2008), an alternative has appeared that seemingly allows anybody to get rich while giving the middle finger to the bankers, financial middlemen, central banks and non believers out there.
Of course, I am talking about the Bitcoin craze.
Some people have recently made very high returns in record time from owning Bitcoin and naturally that attracts widespread attention. Virtually everybody prefers being richer to poorer, and working less to working more…
Therefore, It Is Understandable For People To Want To Put Money Into Bitcoin…
According to wikipedia, Bitcoin is a decentralised digital currency with no intermediary (such as a bank or government) meaning transactions take place directly between users. A public ledger called the blockchain records Bitcoin transactions.
What is Bitcoin? Is it a currency, an asset, a payment mechanism or a new and easy way to speculate?
If it is a new currency, who’s to say it will stick? There are hundreds of new cryptocurrencies out there with more being created constantly. A currency needs to act as a store of value and to maintain price stability – Bitcoin is highly volatile and in a deflationary cycle in that the prices of goods are falling in relation to the rapidly increasing price, so people naturally hoard it. Why buy a car for two Bitcoins today when it may only cost one Bitcoin in a short while?
For it to be classed as an asset, there needs to be some way to value it. There are no cashflows and no way that I know of to calculate its intrinsic value, except on the basis of future price appreciation (this is speculation not investment). Advocates argue fiat currencies are backed by nothing and have no intrinsic value – the same can be said of Bitcoin.
As a payment mechanism, how is it any better than the hundreds of alternatives? If I want to send money to any place in the world I can do that already quickly and easily.
Is Bitcoin simply a new and easy way to speculate? Bitcoin enthusiasts will counter that this is an important innovation that could have important wide ranging applications so it is still cheap…
But Is The Future Really That Easy To Predict?
It is impossible to know for sure what the future holds for any new and potentially disruptive technology. We can however reliably estimate that for every successful major discovery such as the Internet, DNA sequencing, antibiotics, radio and so on there must have been hundreds, perhaps thousands that never got off the ground. Therefore the likelihood of success is very improbable no matter how promising things may seem at first.
This is no great insight of course…
Venture capitalists and R&D departments understand that very, very few new discoveries will ever achieve commercial success and often the successful application is nothing like that first envisaged (the history of the Post-It is a great example).
The trouble is, we only hear of the few innovations that do well (the ‘survivor bias’). This badly skews us into thinking far more innovative ideas succeed than actually do.
So how come the price has risen so much so quickly?
Explaining The Rapid Price Rise Using Narratives…
Throughout history humans have passed on important messages as stories. The human mind is built for stories, especially stories about other human beings (in the case of Bitcoin it’s human beings gambling small amounts and making spectacular easy returns).
Narratives or stories have an epidemic quality to them, they are contagious. And so it is with Bitcoin. Robert Shiller, the Nobel prize winning economist, does a pretty good job of explaining this in the the following video:
Bitcoin is a tech story and technology stocks have done well recently (Amazon, Google, Facebook, Apple and so on..) so it fits into that narrative really well.
Several other factors make the Bitcoin story more contagious:
- Mysterious story about the founder (nobody seems to know who he is or even if he exists).
- Conspiracy stories involving the banks, government, regulators etc. Apparently the ‘elites’ are scared of Bitcoin and want to regulate or stop it…
- Disruption story – without working very much, earn supersize returns (15x in 2017 alone)…
- The story that Bitcoin has already has survived some crashes and therefore it will survive more in the future…
- It’s complicated nature (very few understand how it actually works) lends social kudos to the believers. Bitcoin owners are smart. Ahead of the curve. Cool…
- The early technology companies had a great story. Internet would change the world (it has) but few stopped to think how investors would fare along the way (badly). Investors paid a premium price today but the expected growth did not materialise…
These stories are spread very quickly from person to person via social media and other forms of social communication, fuelling demand even more.
Psychological And Other Factors That Have Driven Bitcoins Popularity (And Price)…
Envy jealousy – my favourite example is the ordinary guy on facebook who posts pictures of his $7m dollar Bitcoin account and asks people whether he should sell now or wait a while? Who could look at that and not feel a little bit envious? Envy/jealousy hits home even harder when friends and family are making easy money…
Anchoring – this is a well documented and scientifically established cognitive bias…
We overweigh events in the recent past and extrapolate short term trends and assume they will keep going – with Bitcoin that’s looking at recent price rises and anchoring on those, rather than thinking correctly about what tends to happen to technical innovations in general.
Scarcity – the fixed supply of Bitcoin is an argument for the continued price rises. Currently 16.7 million Bitcoin outstanding and mining will stop when total reaches 21 million in roughly 2140. More won’t be created but it has always been tempting for those in control of currency to print more of it. Bitcoin not guaranteed to be immune from this all too common and predictable evil (see book). Decent returns are also scarce in the current environment – some investors are so desperate they hand over millions without knowing where it will be invested (link).
Fear of missing out – people are making easy money and boasting about it on social media… You kick yourself for not buying in earlier… Then it keeps going up leading to more regret…
Affect heuristic is a mental shortcut that allows us to make decisions and solve problems quickly and efficiently, in which emotions —fear, pleasure, surprise, etc. —influence decisions. People generally ‘feel’ good about Bitcoin at the moment so they perceive the risks to be low and the benefits high.
Feedback loops – cool new technology… Early adopters… Price goes up. People talk about it. More people want it. Price rises… And so on (the rising price does all the marketing)… Nice video explanation:
Authority – Bitcoin futures now trade on a major exchange… Goldman Sachs is exploring a Bitcoin trading operation… Some retailers accept Bitcoin payments… It is worth reminding ourselves, many of these institutions exist to make money off people trading Bitcoin not Bitcoin itself (getting rich from selling picks and shovels to gold prospectors as opposed to prospecting themselves is a much less risky strategy…)
Confirmation bias – if you already ‘believe’ in Bitcoin then nothing I have said in this post will change your mind. You may even select some of what I have said and take that as an endorsement for Bitcoin investing. If you happen to be against, similarly you’ll look for evidence to support that belief. The trick is to try to keep an open mind and think objectively.
Scaling problem – many things work really well at small scale but fall apart when scaled. Using Bitcoin as a payment mechanism may work great for tech savvy millenials but that does not mean it will necessarily scale to the masses, given the regulations and controls that would need to be imposed.
And if you think people just don’t make important decisions without thinking things through thoroughly, it is worth reflecting that after the Brexit vote, the most popular search term on Google was “what is Brexit?”
The tendencies I have listed above are deeply rooted in evolutionary psychology. They have kept us alive and helped us reproduce but in today’s world we are often led astray.
If I buy something and I make a lot of money did I make a good decision?
Lottery and casino winners make bad mathematical decisions (since the odds are usually clearly and heavily stacked against them) that turned out well due to luck. We do not think about all the players who also played but lost their money since they are not celebrating.
Conversely, I might have made a good decision even if I buy something and I lose money – if the odds and payoffs are clearly in my favour I should invest because more often than not I will win.
It’s impossible to come to an idea of the risks and payoffs related to Bitcoin because the following questions cannot be answered:
- How would the Bitcoin market behave under stress. What are the future possible stresses?
- What technologies could compete with Bitcoin?
- What is the value of a Bitcoin (this is not the price). What is he correct valuation model? Is it robust and dependable?
- Will Bitcoin likely still be around in 3 years? 5? 10?
The market for Bitcoin is relatively small, highly volatile and largely unregulated. It has attracted a lot of true believers and speculators. If many Bitcoin owners tried to sell at once the market will dry up and the price will crash. This is a common theme with mania’s gone by and when prices crash it is always dramatic.
As always I welcome debate. Please feel free to present your analysis. I would like to know how you think about the risks. What models you are using to think about this?
“The easiest thing of all is to deceive one’s self; for what a man wishes he generally believes to be true.” Demosthenes.